Inflation spectre spooks retail investors

Rates were already at a record low when the Bank of England cut the base rate for the first time in more than seven years last summer following the UK's EU referendum, reducing it from 0.5 per cent to a new historic low of 0.25 per cent.

And although home owners with a mortgage have enjoyed the low rates, many experts have begun wondering how plausible it is for UK interest rates to remain low for the foreseeable future.

A popular argument is that rates should remain low, especially because the economy is not overheating, but other industry experts believe it is unwise to assume rates must or even will stay low. This is mainly because such a trend has not been reflected in the US, which has seen the Federal Reserve raise base rates.

David Tan, head of global rates at JP Morgan Asset Management, believes that rates in the US will continue to increase further. 

He said: “The strong growth picture indicates that central banks are justified in reducing ultra-accommodative polices, while the low inflation dynamic suggests they will do so at a very slow and measured pace compared to past cycles. Despite the recent weak US inflation prints, we believe the Federal Reserve will continue to raise rates gradually, given that it is hiking to normalise policy, not to snuff out excessive inflation. In this benign setting, with the Fed neither ahead nor behind the curve, credit risk should continue to be underwritten by the combination of healthy fundamentals and supportive technical conditions in which money needs to be put to work.” 

Mike Riddell, fixed income portfolio manager at Allianz Global Investors, suggested it may be unwise to assume movements in the US have resulted in inflationary pressure or even that it would be replicated in the UK.

He added: “There are no signs of global inflationary pressure. All of the increases in inflation are simply due to energy base effects. Even in the US, which is the developed economy with arguably the tightest labour market, underlying or ‘core’ inflation has actually moved lower recently, not higher.  Nor is there any sign of wage pressure yet.  

“That said, the UK is slightly different as it takes up to 2 years for large currency moves to filter through into inflation.  Sterling fell over 20 per cent from end 2015 to October 2016, so we will be seeing elevated inflation rates until end 2018.  But after that it will normalise, unless sterling continues falling at a rate of 20 per cent each year.”

He added that markets are still expecting some degree of monetary normalisation, a sustained pick-up in inflation, and most people still expect bond yields to rise. 

He added: “We have strongly disagreed with this huge consensus the last six months, and we continue to think that the recent bond rally has further to go as investors come to realise that underlying inflation is not going anywhere.  In fact, if commodity prices fall another 10-plus per cent from current levels, we think there is a chance that the eurozone could be toying with deflation again by the end of this year.”

There is a view that if rates do increase in the UK, then, that mixed with a rise in inflation could spell disaster for the bond markets as this is traditionally seen as its big enemy. 

However, Mel Kenny, chartered financial planner at London-based Radcliffe & Newlands, said we are living in unique times and that the industry must stop assuming the only way bank rates can go is up. He added: “The direction of interest rates is not straightforward. Fund managers led us to believe that from a level of 0.5 per cent the only way was up and yet they went down. America has been raising interest rates, but there is already talk of them coming down. 

“Inflation in the UK could well be a temporary shock and if so, the Bank of England may well keep rates unchanged.”

He added that there is no doubt low yields in bonds represents a conundrum, especially given they have typically been an asset class relied upon by low-risk investors. 

He added that this poses many challenges and suggested that perhaps short duration funds could be a solution.

He added: “A rise in interest rates would especially harm the value of bonds with a long duration. However, for most investors bonds still represent a useful diversifier, but to limit the damage of any rise in interest rates, it is bonds with a short duration that could continue to rise to the challenge.”

This point was also noted by Scott Gallacher, chartered financial planner at Leicester – based Rowley Turton, who agreed short duration funds are definitely one solution, but, alternative investments might offer better value to investors.

He added that another influencing factor that cannot be ignored is Brexit both in terms of the result and how the new terms will be negotiated.

He said: “A key part of the inflation we are seeing at the moment is a result of the fall in the pound following the Brexit referendum. As such in the next few months the inflation rate is expected to fall back when the effects from the fall in the pound have fully worked their way through the system.

“Consequently, I think that the current inflation concerns are unlikely to be a major factor on interest rates. Without the issue of Brexit, I would argue that UK interest rates could remain low for a very long time as there is still little real wage growth or sign the economy is overheating.”

Despite this, he argued that Brexit is the great unknown, and if immigration is restricted, as advocated by many MPs across the political divide, this could lead to a shortage of labour and a rise in real wages. 

He added: “Obviously this would be good for those employees, but would naturally put further pressure on inflation and interest rates.”

However, he argued that if Brexit goes badly then interest rates could be cut to boost the economy, but added there is little room for a cut from today’s levels. Alternatively, it may have to rise to continue to raise money and fund the deficit.

He said: “Overall we see some risk, and little reward, from long-term UK fixed interest holdings and duration risk is of some concern.”

Lucy O’Carroll, chief economist at Aberdeen Asset Management, said after displaying a surprising degree of resilience last year, UK consumers now appear to be retrenching in the face of higher inflation, while other sectors of the economy are struggling to fill the gap. She added that Aberdeen Asset Management expects inflation to continue bearing down on consumption growth this year and next. 

She said: “Tight fiscal policy is likely to add little to growth, while business investment, which declined in 2016, is set for only a modest upturn. Prospects for net trade are better, but are unlikely to offset weakness elsewhere. Driven by earlier currency weakness, headline inflation could peak above 3 per cent this year. But we expect the weakness of economic growth to keep the Bank of England on hold until at least the end of 2019.”

She went on to add that this contrasts with the situation in the US, where growth is expected to receive a boost from fiscal stimulus, including tax cuts and infrastructure spending. 

But she added: “However, the effects of stimulus are unlikely to start materialising until next year, with growth potentially picking up to as much as 2.7 per cent from just over 2 per cent this year. Against this backdrop, we expect the Federal Reserve to raise interest rates twice more this year and to begin tapering reinvestments of maturing assets around the turn of the year. Another three rate hikes in 2018 look likely.” 

Trending in US Federal Reserve

Earlier this year, the US Federal Reserve took the decision to head off rising inflation with its third interest rate rise since the 2008 financial crash. It was the second time it had done so in three months, taking the base rate from 0.75 per cent to 1 per cent.

At the time, the US central bank set aside fears about the impact of higher interest rates on consumer spending to confirm analyst projections that it was prepared to increase rates several times this year to keep a lid on inflation as it rises above its 2 per cent target level.

Janet Yellen, chair at Federal Reserve, insisted a wide range of indicators showed the US economy was in good health, allowing its interest rate setting committee to push rates back towards historically normal levels.

Aamina Zafar is a freelance journalist

Key points

Some industry experts believe it is unwise to assume rates must or even will stay low.

Low yields in bonds represents a conundrum for low risk investors.

A key part of the inflation is a result of the fall in the pound following the Brexit referendum.